Adjustable-Rate Mortgage Loan: What is an ARM and How It Works

An Adjustable-rate Mortgage Loan, also known as an ARM loan, is a type of loan that helps you buy a house. Unlike other loans where the interest rate stays the same, with an ARM loan, the interest rate can change over time. The bank decides on the new interest rate based on things like the economy and the market.

When fixed-rate mortgage rates are high, lenders may start to recommend adjustable-rate mortgages loan (ARMs) as monthly-payment saving alternatives.

Because ARM rates can potentially increase over time, it often only makes sense to get an ARM loan if you need a short-term way to free up monthly cash flow and you understand the pros and cons. In this article, below are the steps of the things we will be looking at.

On this page

  • What is an adjustable-rate mortgage?
  • How does an ARM loan work?
  • What all those numbers in your ARM disclosures mean
  • Types of ARMs
  • How to qualify for an adjustable-rate mortgage
  • Pros and cons of an ARM loan
  • Should you get an adjustable-rate mortgage?

What is an Adjustable-rate Mortgage Loan?

An adjustable-rate mortgage is a type of home loan where the interest rate can change over time. At the beginning, there is a fixed period, usually three, five, or seven years, with a low initial interest rate. After this period the interest goes up and down or is the same on the loan. This depend on two things

  • The index: Which is a banking benchmark that varies with the health of the U.S. economy
  • The margin: It a set of number added to index to determine adjustment rate period.

How does an ARMs loan work?

An adjustable-rate mortgage (ARM) can be a bit complex to calculate because there are different factors involved. The table below provides an explanation of how it all comes together.

ARM featureHow it works
Initial rateProvides a predictable monthly payment for a set time called the “fixed period,” which often lasts three, five or seven years
IndexIt’s the true “moving” part of your loan that fluctuates with the financial markets, and can go up, down or stay the same
MarginThis is a set number added to the index during the adjustment period, and represents the rate you’ll pay when your initial fixed-rate period ends (before caps)
CapA “cap” is simply a limit on the percentage your rate can rise in an adjustment period
First adjustment capThis is how much your rate can rise after your initial fixed-rate period ends
Subsequent adjustment capAfter the initial adjustment period of an adjustable-rate mortgage (ARM) is over, there is a limit on how much the rate can increase for the rest of the loan term. This limit is known as the rate cap and helps protect borrowers from significant interest rate hikes.
Lifetime capThis number represents how much your rate can increase, for as long as you have the loan
Adjustment periodAfter the initial fixed-rate period of an adjustable-rate mortgage (ARM) is over, the rate can typically change every six months or every year.

ARM adjustments in action

To better understand how an adjustable-rate mortgage (ARM) can adjust, let’s take the example of a 5/1 ARM with 2/2/6 caps and a margin of 2%. This means that the initial rate is 5%, and the loan is tied to the Secured Overnight Financing Rate (SOFR) index. Let’s assume the loan amount is $350,000, and we’ll calculate the monthly payment amounts based on these figures.

ARM featureRatePayment (principal and interest)
Initial rate for first five years5%$1,878.88
First adjustment cap = 2%5%
Subsequent adjustment cap = 2%7% (rate prior year)
2% cap
Lifetime cap = 6%5%

The break down of how your interest rate will adjust:

  1. Your rate and payment won’t change for the first five years.
  2. Your rate and payment will go up after the initial fixed-rate period ends.
  3. The first rate adjustment cap keeps your rate from going above 7%.
  4. The subsequent adjustment cap means your rate can’t rise above 9% in the seventh year of the ARM loan.
  5. The lifetime cap means your mortgage rate can’t go above 11% for the life of the loan.

ARM caps in action

The caps on your adjustable-rate mortgage (ARM) are designed to protect you from significant increases in your monthly payment when the rate adjusts. They serve as a safeguard, especially when interest rates rise quickly, as they have in the past year.

The graphic below illustrates how rate caps would prevent your rate from doubling if you started with a 3.5% rate and your loan amount was $350,000, and it was ready to adjust in June 2023.

Starting rateSOFR 30-day average index value on June 1, 2023*MarginRate without cap (index + margin)Rate with cap (start rate + cap)Monthly $ the rate cap saved you
3.5%5.05%*2%7.05% ($2,340.32 P&I)5.5% ($1,987.26 P&I )$353.06

The 30-day average SOFR index shot up from a fraction of a percent to more than 5% for the 30-day average from June 1, 2023, to June 1, 2024. The SOFR is the recommended index for mortgage ARMs. You can track SOFR changes here.

What it all means:

  • Because of a big spike in the index, your rate would have jumped to 7.05%, but the adjustment cap limited your rate increase to 5.5%.
  • The adjustment cap saved you $353.06 per month.

What all those numbers in your ARM disclosures mean

Understanding the various numbers in your adjustable-rate mortgage (ARM) paperwork can be confusing. To simplify things, let’s go through an example that explains each number and its potential impact on your rate.

Assume you’re offered a 5/1 ARM with 2/2/5 caps and an initial rate of 5%. The numbers represent the following: “5/1” indicates that the initial fixed rate will last for 5 years before it starts adjusting annually.

The “2/2/5” caps refer to the maximum rate increase allowed during each adjustment period, the maximum rate increase over the life of the loan, and the maximum decrease allowed, respectively.

What the numbers mean
How the numbers affect your ARM rate
The 5 in the 5/1 ARM means your rate is fixed for the first 5 years
Your rate is fixed at 5% for the first 5 years
The 1 in the 5/1 ARM means your rate will adjust every year after the 5-year fixed-rate period ends
After your 5 years, your rate can change every year
The first 2 in the 2/2/5 adjustment caps means your rate could go up by a maximum of 2 percentage points for the first adjustment
Your rate could increase to 7% in the first year after your initial rate period ends
The second 2 in the 2/2/5 caps means your rate can only go up 2 percentage points per year after each subsequent adjustment
Your rate could increase to 9% in the second year and 10% in the third year after your initial rate period ends
The 5 in the 2/2/5 caps means your rate can go up by a maximum of 5 percentage points above the start rate for the life of the loanYour rate can’t go above 10% for the life of your loan

Types of Adjustable-Rate Mortgage Loan (ARMs)

Hybrid Adjustable-rate Mortgage Loans

Having said this earlier, a hybrid ARM is a type of mortgage that starts with a fixed interest rate and later switches to an adjustable rate for the remaining loan duration. These loans commonly have initial fixed-rate periods of three, five, seven, or ten years, advertised as 3/1, 5/1, 7/1, or 10/1 ARMs.

In some cases, the adjustment period can be as short as six months, meaning the rate could change every six months after the initial period ends. It is important to carefully read the disclosures provided with the ARM program you are considering to understand.

Interest-only Adjustable-rate Mortgage Loans

Certain ARM loans offer an interest-only option, which allows you to make monthly payments that cover only the interest portion of the loan for a specified period, typically ranging from three to ten years. However, it’s important to note that during this time, you won’t be paying down the loan balance. While your monthly payment may be lower compared to a fully amortizing loan.

Payment option Adjustable-rate Mortgage Loans

Earlier to the 2008 housing crash, lenders offered payment option ARMs that provided borrowers with multiple choices for repaying their loans. These options included making principal and interest payments, interest-only payments, or minimum or “limited” payments.

The limited payment option also allows borrowers to pay less than the full interest amount each month, resulting in the unpaid interest being added to the loan balance.

How to Qualify for an Adjustable-rate Mortgage Loan

While both adjustable-rate mortgages (ARMs) and fixed-rate mortgages have similar qualification requirements, it is also important to note that conventional ARMs generally have stricter credit standards compared to conventional fixed-rate mortgages.

We have highlighted this and some of the other differences you should be aware of:

1. You will need a higher down payment for a conventional ARMs

ARM loan guidelines require a 5% minimum down payment, compared to the 3% minimum for fixed-rate conventional loans.

2. You will need a higher credit score for conventional ARMs

More importantly, you may need a score of 640 for a conventional ARM, compared to 620 for fixed-rate loans.

3. You may need to qualify at the worst-case rate

To make sure you can repay the loan, some ARM programs require that you qualify at the maximum interest rate terms.

4. You will have extra payment adjustment protection with a VA ARMs

Eligible military borrowers also have extra protection in the form of a cap on yearly rate increases of 1 percentage point for any VA ARM product that adjusts in less than five years.

Pros and cons of an Adjustable-rate Mortgage Loan

Lower initial rate (usually) compared to comparable fixed-rate mortgages
Rate could adjust and become unaffordable
Lower payment for temporary savings needs
Higher down payment may be required
Good choice for borrowers to save cash if they plan to sell their home and move soonMay require higher minimum credit scores

Should you get an Adjustable-rate Mortgage Loan?

An adjustable-rate mortgage loan (ARM) can be a suitable option if you have specific time-sensitive goals, such as selling your home or refinancing your mortgage before the initial rate period expires.

Furthermore with an ARM, you can possibly take advantage of the lower initial interest rate and potentially save money on monthly payments during that period. If you have extra savings, you may consider applying them towards reducing the principal amount of your mortgage.

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